Investment Risks Evaluation - Essay Example

1. Investment Risks Investment risk refers to the probability and likelihood that the investments made by individuals as well as corporate investorsdo not provide the required returns that were calculated before the decision for the investment was made. There may be a number of investment risks that directly or indirectly affect investments. Some of the key investment risks are discussed below. 1.1 Types of Investment Risks There are many types of risks that an investor faces when making a decision of whether to invest in a company’s shares and securities that are traded on the stock exchange. These risks determine the decision whether a potential investment is required to be made in a company’s securities or not. In addition, these risks are critical in evaluating the amount of investment and the rate of return that is required by investors on their investment with a company. Some of these risks are: Business risk Credit risk Exchange risk Financial risk Liquidity risk Country risk A brief introduction to each of these risks is provided below: 1.1.1 Business/ Company Risk This refers to the poor earning reports, legal actions against company, management ineffectiveness, or potential bankruptcy related issues that might keep an investor from investing into the company’s securities and stocks (Altamira Investment Services, 2003). 1.1.2 Credit Risk Credit risk refers to the possibility that the company will not be able to meet its obligations and pay off its debts as and when these become due. If this situation arises, this could have a drastically negative affect on the company’s performance and its perception into the minds of potential investors. This might also result into a decline in stock prices and may ultimately lead to solvency problems for the company. 1.1.3 Exchange Rate Risk Exchange rate risk is one of the most critical risks for every investment decision. This refers to the situation where movements in exchange rates adversely affect the investments for an individual or the company. The exchange rates may move in favor of or against the investments for people. If exchange rates are decreasing, an investment in a security becomes attractive as other investment modes, like foreign currency, becomes unattractive due to exchange rates being reduced. However, if exchange rates show an increasing trend, an investor might not be willing to invest into a company’s securities until the return from the investment in securities is more than the return from investments in foreign currency. In addition, for multinational companies or for those who try to diversify their portfolio by investing into foreign currencies, exchange risk might be a very critical element to take into account before making the investment. 1.1.4 Financial Risk Finance risk is critical in the evaluation of investment proposals for investing in to a company’s assets and securities. Liquidity risk refers to the situation when the company has no liquidity or cash to meet its obligations. This leads to insolvency and in the longer run, to bankruptcy. This can be calculated by analysing the financial statements for the company and by looking at its cash flow statements. The ratios like current ratio and quick ratio also provide information about the financial liquidity conditions of the company. These ratios should be calculated while making a decision about the financial conditions of a company where the potential investment is to be made. 1.1.5 Liquidity Risk The liquidity risk refers to lack of marketability of an investment in securities or bonds. This means that the investment can not be converted into cash easily when required. This puts a serious limitation on the cash generating capability of a company that might lead to problems in both short and long terms. 1.1.6 Country and Market Risks Some other risks that might be investigated before making an investment decision include country risk and market risks. These risks refer to adverse external environment conditions over which a company has lesser or no control. These risks have to be taken into account when making an investment decision appraisal as these may result into a systemic risk that might impair the entire investment that is being undertaken in a particular company or in a particular sector of the economy, and in the case of country risk, for the entire country. An example can be taken of country risk of United Kingdom versus that of Somalia. Any investment that is made in a UK company may or may not be successful, but an investment made in Somalia is likely to result in loss in most of the circumstances. Hence, the country risk is critical in deciding the fate of an investment. 1.2 Case Study Organisation: Apple Incorporation. Apple is a multinational brand name for computers, operating systems, mobiles and hundreds of electronic items. Apple has offices around the world and provides a number of value added products and services to its customers worldwide. The company was incorporated on 3rd January 1977 under the laws of the State of California. ‘The company designs, manufactures and markets personal computers and related software, services, peripherals and networking solutions’ (Securities and Exchange Commission, 2006). A brief analysis and discussion for investment risks in Apple Incorporation is provided below: 1.2.1 Business/ Company Risk for Apple Apple is a huge multinational company which deals in a number of products and services as stated above. Hence, there is a very low probability of the company getting bankrupt. Hence, the company risk for Apple Computer, Inc is very low and in fact negligible. 1.2.2 Credit Risk for Apple The credit risk for apple is also low. This is because the company has been in business for almost 21 years and has a long and bright credit history. This provides credibility to the company that it almost always honors its claims. Hence, the credit risk for Apple will be treated as very small and will not negatively affect the potential investors’ decision to invest into company’s shares and securities. 1.2.3 Exchange Risk for Apple Apple Incorporation does have to face exchange risk and the volatility of foreign currency rates. Since, the company operates in many countries around the world, a situation may arise that will affect the balance sheet of the company in case of exchange rate movements in the adverse direction. Proper hedging into forward and future contracts is advised to prevent against these risks. 1.2.4 Finance Risk for Apple Apple does not use long term debts and loans to fund its investments as seen from their balance sheets. Hence, there is a small financial risk for the company that might arise from short term loans and obligations that might come due with company having no cash to repay these. However, the risk is ignorable as Apple is mainly an equity financed company. 1.2.5 Liquidity Risk for Apple Apple computers, Inc. has high liquidity as a whole as also shown by the consolidated financial statements for the company. Hence, liquidity risk for the company is quite low. 1.2.6 Country and Market Risk for Apple Since Apple is a multinational company, it does not operate in any one country or any one market for that matter. This provides the capability to the company to adequately hedge itself from adverse country and market risks prevailing in the environment in which the company operates. In addition, this saves the company from having higher than average country risks. In a nutshell, Apple is rated as low in country and market risks from the perspective of investments into the company. 1.3. Conclusion Apple is a huge multinational that operates in a number of countries. This it self provides the ability to the company to hedge its risks. Altogether, as seen from above, Apple is a low risk and high return company for a potential investor who is planning to invest in to Apple’s securities and/ or stocks. 2. Gearing 2.1 Introduction The decision to introduce gearing into a company may be a good one or may lead to problems for the company depending on the circumstances. 2.2 Effects of Gearing There are both positive and negative impacts of introducing gearing into the capital structure of a company. These are discussed below: 2.2.1 Benefits of Gearing Gearing, if introduced into a company’s capital structure will allow the company to expand its operations since the management can now undertake more projects. The excess cash that is obtained through debt can be used to initiate other capital projects and undertake capital expenditures. If this is the case, the shareholders will benefit from the introduction of gearing into the company’s capital structure as this would mean an increase in operations that might lead to an increase in profits for the company. Since, stockholders are the owners of the company, an increase in profit would result in an increase in dividends, share values being increased and an increase in earning per share for the company. 2.2.2 Disadvantages of Gearing An optimal capital structure maxmises the net value of the company. However, the introduction of gearing into the company’s capital structure might lead to some problems for the company. These problems might include a difficulty into servicing the debt which will ultimately result into liquidity problems for the company. Since, introducing gearing into the company means introducing interest payables, this might mean that the company will have to pay regular interests to meet its obligations arising from the debt. If the company is unable to generate adequate cash, this will result into insolvency and difficulty in managing the finds. The ultimate result is the bankruptcy for the company. The investors, of course, will not like the company to go bankrupt since their money will be stuck if this happens. Hence, they would oppose the introduction of gearing into the company’s capital structure. If this is considered, the company should not include gearing into its capital structure for investors’ sake. 2.2.3 Apple Computer, Incorporation Apple has no long term debt and liabilities as shown by the balance sheet of the company (Finance Yahoo.com, 2007). The company’s capital structure predominantly consists of preferred stock, redeemable stocks, and common stocks. The lack of long term debt gives relatively a better feeling to the potential investors. Although, one may feel that introduction of gearing should increase the ability of the company to undertake long term projects that would benefit the company and its investors in the long run, however, the company’s management has decided to take no long term debt as per their balance sheet on 30th September 2006. The capital structure of the company thus, is without noticeable gearing and hence solely depends on the stocks or equity. This might not be the best idea to implement virtually no gearing at all and may have to be studied in detail to find out if this is the structure that most optimally maximises the value of the company. However, considering the fact that Apple is managed by some of the finest finance managers of the world gives a certain degree of easiness to the investors, though this should not be treated as the de facto standard. Many cases in the past have shown that companies got vulnerable to the wish of having no gearing at all; and ultimately suffered. A little gearing is in fact desirable for achieving long term goals and providing benefits to the stockholders. Hence, Apple is recommended to introduce a slight gearing into the capital structure of the company which will ultimately be beneficial for the company. 2.3 Conclusion As stated above, gearing can be good or bad; it depends on how much and to what extent it is being introduced into the company. It depends on the company to decide whether to introduce gearing into the capital structure of the company. Apple Computer has no gearing into its capital structure currently, yet it is expected that gearing will be introduced up to a controlled level. This would assist in making capital investments by the company into projects that would ultimately lead to an increase in stockholders’ interests into the company. Hence, stockholders will prefer a slight introduction of gearing into the company. 3. Investment Appraisal Techniques 3.1 Introduction Since the ultimate objective of every investment it to produce attractive returns for the shareholders, the investment managers need to employ sound techniques to evaluate the expected revenue streams from the investment. The total revenues should out perform the total cost associated with the investment in order for it to be attractive for the company’s management and to maximise shareholders’ wealth. Some of the techniques that can be used for this purpose include the following: 3.2 Discounted Cash Flow Technique Discounted Cash Flow (DCF) is a popular method appraising an investment opportunity by finance managers. It refers to estimating future cash flow projections and discounting them at the weighted average cost of capital (WACC) to arrive at the present value, which is then compared with the current cost of investment. If the discounted value is higher than costs, the project should be accepted otherwise rejected. 3.3 Net Present Value Calculation Net Present Value (NPV) is used to calculate the total revenues that the proposed project will provide to the business net of the costs associated with implementing and operating the project. This is discounted with the interest rate to arrive at the net present value for the project. Essentially, NPV is the difference between present value of cash inflows and the present value of cash outflows. 3.4 Internal Rate of Return Internal Rate of Return (IRR) is another measure to evaluate the attractiveness of investment alternatives. It is the discount rate at which net present value of the cash inflows and outflows becomes equal such that NPV is zero. Any project that promises a return higher than this should be accepted. As a general rule, the higher the internal rate of return for a project, the better are its chances for selection. 3.5 Payback Period This is another method of evaluating the attractiveness of a project and refers to the number of years (or months) required to break even. That is, to get enough revenues that equals the cost that was incurred for making the investment. 3.6 Evaluation of Investment in Securities If the finance managers are evaluating the investment opportunities with regard to securities, they need to concentrate upon the market risk that affects the security, and the risk free rate of return that investors can get by investing in securities like treasury bills. Hence, the rate of return should be somewhat higher than the risk free rate of return and should take into account the market risk premium for the security. The general idea is that the investors need to be compensated as per the time value of money and the risk associated with the investment. The model is called Capital Asset Pricing Model (CAPM) and provides the suitable rate below which investment should not be made considering the risks involved with the investment. 3.7 Conclusion There are many other techniques for investment project appraisals that the finance managers use to select the best alternative for investing shareholders’ money. Since, ultimately the company’s target is to enhance the return to shareholders, a careful analysis of investment is essential for a successful outcome. It is recommended that all investment proposals should be first evaluated using a number of techniques listed above before a final decision is made for selecting a particular project. This would ensure that most optimal solution is selected that would give maximum return on investments for the investors and investing companies. References Altamira Investment Services (2003) Risks [Internet]. Available from: [Accessed May 10, 2007]. Securities and Exchange Commission (2006) Apple Computer Inc. [Internet]. Available from: [Accessed May 9, 2007]. Finance Yahoo.com (2007) Apple Inc.: Balance Sheet [Internet]. Available from: [Accessed May 11, 2007]. Read More